History 101

There was Real Economic Activity in the Twenties so the Great Depression should only have been a Recession

The Great Depression began with the Stock Market Crash of 1929. Which led to a period of record unemployment. On average the unemployment rate was 13.46% during the Thirties. Or, if you don’t count all of the make-work government jobs, 18.23%. So what caused this unemployment? Was it the expansionary monetary policy of the Twenties? The Keynesians thought so. Even the economists from the Austrian school of economics thought so. The only ones to have predicted the Great Depression. So were they right? A little bit.

Yes, there was monetary expansion during the Twenties. So a recessionary correction was inevitable. But a depression? When you look at the economic activity of the Twenties, no. The Roaring Twenties were a transformative time. It was when we began to say goodbye to the steam engine. And said hello to electricity. We said goodbye to the horse and buggy. And said hello to the automobile. We said goodbye to the horse and plow. And said hello to the tractor. As well as said hello to radio, motion pictures, air travel, electric lighting and electric appliances in the home, etc. So there was real economic activity in the Twenties. It wasn’t all a bubble. So the Great Depression should have only been a regular recession. But it wasn’t. So what happened?

Government. The government interfered with market forces. Based on Keynesian advice. They said the government needed to increase aggregate demand. As that demand would encourage businesses to expand and hire new workers. Thus lowering the unemployment rate. And part of increasing demand was keeping wages from falling. So people had more money to spend. Of course, if employers were to continue to pay higher wages that meant that prices could not fall. Like they normally do during a recession. So the Keynesian advice was to prevent the market from correcting prices to match supply to demand. Prolonging the inevitable recession. But there was more bad government policy.

The Keynesian Cure for Unemployment is Inflation

The stock market was soaring in the late Twenties. Because of that real economic growth. So what happened to that economic growth? Well, in part, the Smoot Hawley Tariff of 1930. Which was in committee in 1929 before the great crash. But investors saw it coming. And they knew tariffs rising as much as 50% were going to cool those hot earnings they’ve been enjoying. As well as Herbert Hoover’s progressive plans. Who would go on to double income tax rates. When Herbert Hoover won the 1928 election the writing was on the wall. And investors bailed. Especially when the Smoot Hawley Tariff was moving through committee. Because raising the cost of doing business does not help business. So the great earnings ride of the Twenties was ending and the investors sold their stocks to lock in their profits. Precipitating the Stock Market Crash of 1929. And the record unemployment that would follow. And the Great Depression.

So the Keynesians got it wrong during the Thirties. Their next grand experiment would be in the Seventies. As government spending took off thanks to the Vietnam War, the Great Society and the Apollo moon program. There was so much spending that they had to print money to pay for it all. As they did, though, they devalued the dollar. Which became a problem. As the U.S. at the time agreed to exchange gold for dollars at $35/ounce. So when the Americans made their dollar worth less our trading partners decided to take our gold instead. Gold flew out of the gold window. So to stop this gold flow out of the country Nixon did what any Keynesian would do. No, he didn’t cut back spending. He decoupled the dollar from gold. Slamming the gold window shut. Without any advanced warning to the world. So we now call this action he took on August 15, 1971 the Nixon Shock. The Keynesians were thrilled. Because they now had no restraint in printing new money.

The reason Keynesians were happy to be able to print more money was because that was their cure for unemployment. Inflation. When the economy goes into recession it was just a simple matter of expanding the money supply. Which lowers interest rates. Which makes businesses who had no intention to expand their businesses borrow money to expand their businesses. So to pull the economy out of recession they inflated the money supply. And did it work? No. Of course it didn’t. It just raised prices. Increasing the cost of business. As well as leaving consumers with less real income. So, no, the economy didn’t improve. It just stagnated. The average unemployment rate during the Seventies was 6.21%. While the average inflation rate was 7.08%. Also, the top marginal tax rate of 70%. Which didn’t help the anti-business environment.

The Subprime Mortgage Crisis and the Great Recession were Direct Consequences of Bad Monetary Policy

So the Keynesians failed. Again. Their inflationary monetary policy only made things worse during the Seventies. All of that inflation just kept pushing prices ever higher. Ensuring that the inevitable recession to correct those prices would be long and painful. Which it was. In the early Eighties. Then Paul Volcker rang out all of that inflation. And Ronald Reagan began bringing the top marginal tax rate down until it was at 28% by the end of the decade. Making a more favorable business environment. So business grew. And began to hire new workers. Teaching an economic lesson some in government refused to learn. Keynesian inflationary monetary policies did not work.

During the Nineties the Keynesians were back. Inflating the money supply slowly but surely to continue an economic expansion. Making money available to borrow. And borrow it people did. Creating a long and sustained housing boom that would last for about 2 decades. That expansionary monetary policy gave us cheap mortgages. Making it very easy to buy a house. Housing prices rose. And continued to rise during those two decades. Then President Clinton had his Justice Department tell banks to lower their standards for approving mortgages for the unqualified. So everyone could buy a house. Even if they couldn’t afford to pay for it. Ushering in the subprime mortgage industry. Further increasing the demand for houses. And further driving up housing prices. Making the inevitable correction a long and painful one.

Meanwhile, there was something new in the market place in the Nineties. The Internet. And new Internet start-ups (dot-coms) flooded the market. Investors poured money into them. Even though they didn’t have a product to sell. And had no earnings. But investors were exuberant. And irrational. Kids flooded into universities to get degrees in computer science. To staff all of those Internet start-ups. Companies went public. Creating a stock market bubble as investors scrambled to buy their stock. They raised a boatload of money from those IPOs. And spent it all. Many without producing anything to sell. And when that money ran out they went bankrupt. Bursting that stock market bubble. And throwing a lot of computer scientists out of a job. Causing a painful recession in the early 2000s that George Bush helped mitigate with tax cuts.

And low interest rates. People were back buying houses. But this time they were buying McMansions. Because that easy monetary policy gave us cheap mortgage rates. And subprime, no-documentation, zero down loans, etc., made it easier than ever to buy a house. Housing prices soared. And builders flooded the market with more McMansions. Pushing prices ever higher. Fannie Mae and Freddie Mac were buying those toxic subprime mortgages from banks to encourage them to approve more toxic subprime mortgages. Pushing the inevitable correction further and further out. Running up prices so high that their fall would be a long and painful one. Which it was when the subprime mortgage crisis hit. As well as the Great Recession. Direct consequences of bad monetary policy. And the government’s interference into market forces.